Credit card and auto loan standards have tightened in 2019.
Banks' conservatism in lending is a good sign for stock market bulls.
Bull markets typically end when lending standards markedly deteriorate.
While stock prices continue their upward march, small investors remain remarkably subdued in the face of new highs in the S&P 500. Nowhere is the rush to buy at any cost visible on the market's horizon, and if the latest AAII sentiment poll is any indication, there's still a great deal money on the sidelines. In this report we'll look at data from the Fed which shows that lending standards are getting tighter. I'll make the case that tighter standards are a sign of the financial market's health and prove this bull still has plenty of life ahead of it.
One of the most common characteristics of a major peak in any bull market is the degradation of lending standards among creditors. Looking back at any of the frothy periods which preceded prior peaks in equities and real estate, one can't help but notice the tendency toward easy lending conditions. Whether it was the easy consumer credit of the late 1990s or the "come one and all" mortgage lending trend during the 2000s real estate boom, lighter standards have always been the hallmark of the bull in the days leading up to its death.
Today there are quite a few market pundits who insist that the bull market which began in 2009 is in just such a moribund condition. They offer as proof of this opinion the difficulty that several of the major indices have had in making new highs in the last few months. They're also quick to point out the lagging tendency of some economically sensitive market segments, including the important transportation stocks.
Yet there is one glaring contradiction to the bears' thesis, and that's the conspicuous lack of loose lending standards. In fact, quite the opposite trend can be seen among lenders today. This was pointed out in an article by Greg Robb, who noted that banks tightened lending standards on credit cards and auto loans in the recent quarters. As Robb pointed out, the latest Federal Reserve survey of senior loan officers found that
Banks have increased underwriting standards for approving credit card applications for the past three quarters. In the January-March quarter, credit card standards tightened the most since 2009, according to a report from Moody's Investors Service."
The survey also revealed that banks were "less likely to approve credit card and auto-loan applications by borrowers with FICO scores of 620 than they were at the beginning of the year." The Fed's survey also showed that there was no increase in loan demand among borrowers with higher credit scores. Loan officers based their tighter standards on their concern over an uncertain economic outlook, according to the Fed.
From the Fed's latest loan officer survey, we can conclude that not only are financial institutions embracing a conservative posture when it comes to lending money to consumers, but even credit worthy borrowers aren't showing an appetite for debt right now. This is hardly the backdrop of a typical bull market peak. Rather, it suggests that the bull rests on a fiscally sound footing where banks and consumers are concerned. It further implies that we've not yet reached the frothy, giddy stages that are typical of a bull market that has reached the end of its lifespan.
The bottom line is that banks and consumers alike are showing a great deal of restraint. And this restraint isn't at all typical of the "irrational exuberance" which normally accompanies a peaking stock market.
Another sign which often accompanies a dying bull market is the tendency for banks and the overall financial sector to show balance sheet deterioration. Bank stocks also frequently underperform the S&P 500 during the final distribution phase before a bull market ends. Yet, the latest data suggests that banks are still in good shape, partly as a result of their lending restraint. According to the latest info from FactSet, the financial sector was the leader in the latest quarterly earnings reports in terms of beating revenue estimates. For Q3, 85% of financial sector companies beat revenue estimates to remain above the 5-year average. Moreover, within the financial sector of which banks command a sizable share, companies have the lowest forward P/E ratio (12.4) of all S&P sectors.
A manifest token of the conservative lending standards and market-beating revenues of U.S. banks is the following graph. It shows the clear and conspicuously strong performance of the industry benchmark PHLX/KBW Bank Index (BKX). Many U.S. regional and institutional bank stocks are emerging from year-long trading ranges and have lately made new highs, even before the S&P 500 Index (SPX) did. This can only be considered as a bullish harbinger for the U.S. broad market and a sign of the bull's good health.
With the outlook for banks as good as it has been since at least 2017, sidelined investors should cast aside their doubts and assume a best-case scenario for the financial sector. The fact that banks have embraced a conservative lending policy is an encouraging sign and an anecdotal proof that the bull which began in 2009 still lives on. Given the strong fundamental underpinning of the financial sector discussed here, investors are therefore justified in maintaining intermediate-term (3-6 month) long positions in equities.
On a strategic note, I'm currently long the Invesco S&P 500 Quality ETF (SPHQ), which is my preferred broad market tracking fund. I'm using a level slightly below the $33.00 level as the initial stop-loss for this trading position on an intraday basis.
Disclosure: I am/we are long SPHQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.